North American Outlook
January 02, 2025 | 13:48
Tailwinds and Tariffs
Economics
Economics
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United StatesBarring a major trade war, 2025 should be another good year for the economy. Lower interest rates and inflation, rising incomes, and the positive wealth effect of the S&P 500's 23.3% surge in 2024 should propel consumer spending. Trump's pledge to repeal income taxes on tips, overtime pay, and seniors' benefits should support consumer confidence even if it may not take effect until 2026 and could be tempered by deficit concerns. Similarly, business investment will benefit from lighter regulation and potentially lower corporate taxes. A recent bounce in existing home sales from 14-year lows suggests the housing market—arguably the biggest casualty in the Fed's war on inflation—will see better days ahead. Still, growth is likely to downshift a bit from the past two years. After a strong run, government spending will come under the knife of the new Department of Government Efficiency, even if Congress has the final say on most measures. As well, despite firmer global demand, exports will be constrained by the trade-weighted dollar's 7.1% appreciation in 2024 to record highs. On balance, real GDP growth looks to moderate but stay healthy at 2.3% in 2025 following an estimated 2.8% rate in 2024. Our above-consensus call should keep the unemployment rate near current levels, averaging 4.3% for the year. Due to sticky services costs, inflation appears to have finished 2024 pretty much the way it started the year: with progress stalling. Moderating food costs and falling fuel prices reduced personal expenditure inflation to 2.4% y/y in November from 2.7% a year ago, but the core (ex-food and energy) rate is running faster at 2.8% and core services (ex-housing and energy) inflation is stuck above 3%. We expect the Fed's target measure for inflation to average 2.2% in 2025, before hitting the bullseye in early 2026. This assumes some further moderation in rental rates. Moreover, looser labour market conditions should slow wage increases. That, along with sturdy gains in productivity (2.0% y/y in Q3), should keep unit labour costs (2.2%) in check. |
After cutting policy rates by 100 basis points within three months to a midpoint of 4.38%, the Fed is planning a slower pace of easing. Chair Powell says the shift reflects higher-than-expected inflation and policy rates that are now "significantly closer to neutral", even if "meaningfully restrictive". A rate pause is widely expected in January. Still, with inflation expected to grind lower, we see three more rate trims totaling 75 basis points this year—one more than expected by the median FOMC member and the futures market. Two more cuts are likely in 2026, bringing rates down to a more neutral level of 3.13%. Despite lower policy rates, 2024 was a lousy year for Treasuries. The 10-year yield rose nearly 70 bps to 4.57%, largely due to inflation concerns stemming from the strong economy, stimulative fiscal policies, and tariff threats. A federal budget deficit of nearly $2 trillion, or almost 7% of GDP, also weighed by keeping supply flush. Still, continued Fed easing should support a downward move in the benchmark rate to around 4.0% by yearend. By contrast, corporate bonds, which trounced Treasuries last year as double-digit profit growth led to an 84-bp compression in high-yield spreads, could underperform if tariffs disrupt business performance. Trade protectionism is a key risk to the expansion, especially if it reheats inflation. Trump's threat to impose import duties of 25% on Canada and Mexico, 10%-to-20% on other countries, and at least 60% on China, combined with potential retaliatory tariffs on U.S. exports, risks a prolonged bout of stagflation, whereby the economy slows sharply while the Fed's hands are partly tied by a temporary spike in inflation. The duties on Canada and Mexico could take effect on the first day of Trump's return to the Oval Office. Before that, the economy will need to dodge a potential port workers' strike along the East and Gulf coasts on January 15 that could be highly disruptive if it lasts longer than a few weeks. CanadaAmid weak business spending, economic growth likely slowed modestly to 1.3% in 2024 from 1.5% in 2023. The economy's performance in recent months fits with its 'two steps forward one step back' pattern of the year. Led by gains in energy and mining, real GDP rose 0.3% in October after a decent advance in September, though the initial read for November calls for a slight decline. Though lacking momentum, growth is expected to improve to 2.0% in 2025, assuming the country dodges tariffs. Interest-sensitive households are responding to the central bank's aggressive easing campaign, which allowed debt-service costs to retreat from record highs and mortgage holders to refinance at rates below stress-tested levels. The TSX's 18.0% rally in 2024 and now rising home prices are fanning the wealth effect. After a two-year slumber, the housing market has awakened, with existing home sales rising for four straight months and returning to normal levels in November. A low Canadian dollar will also support exports this year. Meantime, regardless of which party wins the federal election (which must be held by October 2025 but could come sooner after the NDP withdrew its long-standing support for the ruling Liberal Party), policies will need to be refocused on spurring investment to prevent a further erosion in competitiveness, especially in the wake of proposed business-friendly policies from the incoming U.S. administration. The economy faces a potential headwind from slower population growth. The federal government will sharply cut the number of temporary resident permits in a bid to shrink the population slightly in the next two years. The immigration U-turn is an attempt to correct for the unsustainable increases of recent years. While the task could prove daunting considering the lengthy backlog in processing asylum claims and pressure from U.S. deportations, population growth looks to slow materially from 3% annually to less than 1%. Still, the more subdued spending power of temporary residents compared with permanent residents should soften the economic impact. Despite creating 329,300 jobs in the past year to November, businesses and governments couldn't keep pace with scorching labour force growth, resulting in the unemployment rate rising another one percentage point. At 6.8%, the current rate is the highest in nearly eight years, apart from the pandemic wildness. The unemployed are not only competing with more job seekers but also for fewer available jobs, as vacancies have returned to pre-pandemic levels. As population growth slows and the economy picks up, the jobless rate is expected to retreat modestly later this year after peaking at 7.0%. Looser labour markets and lower fuel costs have countered a weaker loonie to pull CPI inflation down to 1.9% y/y in November from 3.4% at the start of the year. While key core measures are tracking moderately higher, economic slack should hold inflation to an average 1.8% rate in 2025. After chopping policy rates another 50 bps in December and by 175 bps since the summer—the most among major central banks—the Bank of Canada says it will take "a more gradual approach to monetary policy", as the current 3.25% overnight rate is now at the upper end of a neutral range. Moreover, rate-sensitive areas of spending, such as home and auto sales, are already bearing fruit. We expect the Bank to stand pat in January before trimming rates by 25 bps in March, June and September, taking the policy rate down to 2.5%, or the low end of neutral. The Bank would abandon its gradual approach, however, if the economy gets hammered by tariffs. Canada bonds outperformed Treasuries in 2024 due to a weaker economy, lower inflation, and aggressive central bank easing. Barring a trade war, however, it could lag this year as the economy picks up. After rising 12 bps to 3.23% in 2024, the 10-year rate is expected to decline modestly to 3.0% by yearend. Faced with historically wide interest-rate spreads with the U.S. and staring down the double barrel of punishing tariffs and tough talks to renew the USMCA, the Canadian dollar is a proverbial sitting duck. The loonie depreciated 7.9% in 2024 to a near two-decade low of 69.5 cents US. Of some consolation, it weakened only modestly on the crosses. This is largely a story of U.S. dollar supremacy, as an outperforming U.S. economy is generating more attractive returns than in other countries, including Canada, drawing capital to that country. We suspect the loonie will remain on the defensive for a while, though if the country successfully sidesteps tariffs, it could climb toward 72 cents US by yearend. A 25% duty on everything Canada sells to the U.S. starting on January 20 could tip the economy into recession. Retaliatory tariffs would only pile on the pain via higher prices for consumers and higher costs for businesses, undermining hopes of a revival in living standards and productivity. While the central bank and governments wouldn't stand still, 2025 could be the third year of soggy growth rather than the best year of the past three. |
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